Microeconomics: Hall and Lieberman
What is Economics?
Economics is the study of choice under conditions of scarcity.
Scarcity and Individual Choice
Scarcity- a situation in which the amount of something available is insufficient
to satisfy the desire for it.
As individuals, we face scarcity of time and spending power. Given more of
either, we could each have more of the goods and services that we desire.
Because of the scarcities of time and spending power, each of us is forced to
Economists study the choices that we make as individuals along with their
consequences. When some of the consequences are harmful, economists
study what-if anything-the government can or should do about them.
The Concept of Opportunity Cost
o The opportunity cost of any choice is what we must forgo when we
make that choice. It is the most accurate and complete concept of
o When the alternatives to a choice are mutually exclusive, only the next
best choice-the one that would actually be chosen-is used to
determine the opportunity cost of the choice.
o An Example: The Opportunity Cost of College
Explicit cost- the dollars sacrificed-and actually paid out-for a
choice. This is part of opportunity cost.
Implicit cost- the value of something sacrificed when no
direct payment is made.
The opportunity cost of a choice includes both explicit and
o A Brief Digression: Is College the Right Choice?
Attending college appears to be one of the best financial
investments you can make.
o Time is Money
The explicit (direct money) cost of a choice may only be a
part-and sometimes a small part-of the opportunity cost of a
Scarcity and Social Choice Scarcity of resources is what is holding us back from accomplishing the
goals of society that would satisfy everyone. In society’s case, the
problem is a scarcity of resources.
Resources- the labor; capital, land (including natural resources),
and entrepreneurship that are used to produce goods and services.
The Four Resources
Labor: The time human beings spend producing goods and
Capital: A long-lasting tool that is used to produce other
Physical Capital- the part of the capital stock
consisting of physical goods, such as machinery,
equipment, and factories.
Human capital- The skills and training of the labor
If something is used up quickly in the production
process it is generally not considered capital.
Capital stock- The total amount of capital in a nation
that is productively useful at a particular point in time.
Land- The physical space on which production takes place, as
well as the natural resources that come with it.
Entrepreneurship- The ability and willingness to combine the
other resources into a productive enterprise.
Anything produced in the economy comes, ultimately, from
some combination of the four resources.
Resources v. Inputs
o An input is anything used to make a good or service. Inputs include
not only resources but many other things made from them
(cement, rolled steel, electricity), which are, in turn, used to
produce goods and services.
o Resources, by contrast, are the special inputs that fall into the four
categories. They are the ultimate source of everything that is
Opportunity Cost and Society’s Tradeoffs o Virtually all production carries an opportunity cost: To produce
more of one thing, society must shift resources away from
producing something else.
o For a society opportunity cost arises from the scarcity of resources
whereas for an individual it arises from the scarcity of time or
The World of Economies
Microeconomics and Macroeconomics
o Microeconomics: derived from the Greek word “mikros” meaning
small. It is the study of the behavior of individual households,
firms, and governments; the choices they make; and their
interaction in specific markets.
o Macroeconomics: derived from the Greek word “makros” meaning
large- takes an overall look at the economy. It focuses on the big
picture and ignores the fine details.
Positive and Normative Economics
o Positive economics deals with how the economy works plain and
o Normative economics is the practice of recommending policies to
solve economic problems. It goes beyond the facts and tells us
what we should do about them.
o Every normative analysis is based on an underlying positive
o A normative analysis is always based, at least in part, on the values
of the person conducting it.
o Why Economists Disagree about Policy
Policy differences among economists arise from (1) positive
disagreements (about what the outcome of different policies
will be), or (2) differences in values (how those outcomes
Why Study Economics?
To Understand the World Better
To achieve social change
To help prepare for other careers
To become an economist
The Methods of Economics Economics has a heavy reliance on models.
A model is an abstract representation of reality.
A model represents the real world by abstracting or taking from the real
world that which will help us understand it.
The Art of Building Economic Models
o A model should be as simple as possible to accomplish its purpose.
It should contain only necessary details.
o The level of detail that is perfect for one purpose will usually be too
much or too little for another. Example: Maps
Assumptions and Conclusions
o Every economic model makes simplifying and critical assumptions.
o A simplifying assumption is any assumption that makes a model
simpler without affecting any of its important conclusions.
o A critical assumption is any assumption that affects the conclusions
of a model in an important way.
See Appendix Chapter Two: Scarcity, Choice, and Economic Systems
Society’s Production Choices
The opportunity cost of having more of one good is measured in the units
of the other good that must be sacrificed.
The Production Possibilities Frontier
Production Possibilities Frontier (PPF)- A curve showing all combinations
of two goods that can be produced with the resources and the technology
Points outside the frontier are unattainable with the technology and
resources at the economy’s disposal. Society’s choices are limited to
points on or inside the PPF.
Increasing Opportunity Cost
o According to the law of increasing opportunity cost, the more of
something we produce, the greater the opportunity cost of
producing even more of it..
o It is this law that causes the PPF to have a concave (upside-down)
The Reason for Increasing Opportunity Cost
o Because most resources are better suited to some purposes than to
others. As we shift more and more resources towards the
production of a second good at first the resources that were more
suited would be moved but as production of the second good
increases more resources that are more apt to the first one get
moved to the second.
The Search for a Free Lunch
A meal is not really free because society still uses up resources to provide it.
Society pays an opportunity cost by not producing other things with those
Operating Inside the PPF
o When an economy is not living up to its productive potential.
o Productive Inefficiency
Resources are not being used in the most productive way.
Productively Inefficient- a situation in which more of at least
one good can be produced without sacrificing the production
of any other good.
Productive efficiency means the absence of any productive
inefficiency. No firm is ever 100% productively efficient. Business firms have strong incentives to identify and
eliminate productive inefficiency, since any waste of
resources increases their costs and decreases their profits.
Some inefficiencies aren’t fixed (like federal tax returns)
because of lobbying and that it will hurt some people who
resist changes in the status quo.
A recession is another reason an economy may operate
within it’s PPF.
During a recession many resources are idle. An end to a
recession would move an economy from a point within it’s
PPF to a point on it, as it would use idle resources to produce
more goods and services without sacrificing anything.
False benefits from employment: Example how spam has put
software engineers to work during a recession, however,
these engineers would have jobs in more vital areas if there
was no recession so when the recession ends, employment in
the spam-fighting industry is the opportunity cost of spam.
o One way productivity capacity grows is by an increase in available
resources. The resource that has contributed the most is capital.
o The other major source of economic growth is technological
change-the discovery of new ways to produce more from a given
quantity of resources.
o A technological change or an increase in resources, even when the
direct impact is to increase production of just one type of good,
allows us to choose greater production of all types of goods.
o Consumption vs. Growth
Capital plays two roles in the economy. It is a resource that
we use to produce goods and services and is a also a good
itself and is produced using resources.
Each year we must choose how much of our available
resources to use to produce capital, which is a long lasting
tool but its production leads to less consumption goods being
made. In order to produce more goods and services in the future,
we must shift resources towards Research and Development
and capital production, and away from producing things we’d
enjoy right now.
The way our economy is organized
Specialization and Exchange
o Every economic system has been characterized by two features:
Specialization, which is a method of production in which each
person concentrates on a limited number of activities, and
exchange, in which most of what we desire is obtained by trading
with others rather than producing for ourselves.
o Specialization and exchange enable us to enjoy greater production
and higher living standards than would otherwise be possible. As a
result, all economies exhibit high degrees of specialization and
o Where do gains from specialization and exchange come from?
Development of expertise- by limiting ourselves to a narrow
set of tasks, we can hone our skills and become experts of
one or two things rather than amateurs at a lot of things.
Minimizing downtime- there is less unproductive downtime
that would result from switching activities, as people spend
their time doing one kind of task.
Comparative advantage- allocating resources according to
their suitability for different types of production, leads us to
get further gains from specialization.
Absolute Advantage: A Detour
o An individual has an absolute advantage in the production of some
good when he or she can produce it using fewer resources than the
other individual can.
o the absolute advantage is an unreliable guide for allocating tasks to
o The ability to produce a good or service at a lower opportunity cost
than other producers. Gains from Comparative Advantage
o When each castaway moves toward producing more of the good in
which he or she has comparative advantage, total production rises.
o In the end specializing, according to comparative advantage and
exchanging with each other gives the castaways a higher standard
of living than they could each achieve on their own.
Beyond the Island
o Total production of every good or service will be greatest when
individuals specialize according to their comparative advantage.
This is another reason why specialization and exchange lead to
higher living standards than does self-sufficiency.
International Comparative Advantage
o A nation has comparative advantage in producing a good if it can
produce it at a lower opportunity cost than some other nation.
o Examples in book: Chinese and American Soybean and t-shirt
Global gains from comparative advantage
o Total production of every good or service is greatest when nations
shift production toward their comparative advantage goods, and
trade with each other.
Societies are confronted with three important questions.
Which goods and services should be produced with society’s resources?
o Where on it’s PPF should the economy operate?
How should they be produced?
o Most goods and services can be produced in a variety of ways, with
each method using more of some resources and less of others.
Who should get them?
o Determining who get’s the economy’s output is always the most
controversial aspect of resource allocation. Over the last half-
century, our society has become more sensitized to the way goods
and services are distributed, and we increasingly ask whether
distribution is fair.
The Three Methods of Resource Allocation
o Traditional Economy- An economy in which resources are
allocated according to long-lived practices from the past. Remains strong in many tribal societies and small villages in
parts of Africa, South America, Asia, and the Pacific.
Serious drawback of this economy is that they don’t grow.
With everyone locked into traditional patterns of production,
there is little room for innovation or technological change.
Traditional economies are likely to be stagnant economies.
o Command or Centrally Planned Economies- An economic
system in which resources are allocated according to explicit
instructions from a central authority.
They are disappearing fast, the only two that are left today
are Cuba and North Korea.
o Market Economy- An economic system in which resources are
allocated through individual decision making.
In a market economy, freedom of choice is constrained by
the resources one controls
In a market system, those who control more resources will
have more choices available to them than those who control
fewer resources. Nonetheless, given these different starting
points, individual choice plays the major role in allocating
resources in a market economy.
Resources can be allocated through markets and prices.
The Nature of Markets
o A market is a collection of buyers and sellers who have the
potential to trade with one another.
o The market can be global, which is when buyers and sellers are
spread across the globe. In other cases the market is local.
o Markets play a major role in allocating resources by forcing
individual decision-makers to consider their decisions about buying
and selling. They do so because of an important feature of every
market: the price at which a good is bought and sold.
The Importance of Prices
o A price is the amount of money that a buyer must pay to a seller
for a good or service.
o Price is not always the same as cost. o Prices are so important to the working of the economy because
they confront individual decision makers with the costs of their
A Thought Experiment: Free Cars
o We’d end up paying for the cars in the end as much of our available
labor, capital, land and entrepreneurial talent would be put towards
cars rather than education, medical care and perhaps food.
o When resources are allocated by the market, and people must pay
for their purchases, they are forced to consider the opportunity cost
to society of their individual actions. In this way, markets are able
to create a sustainable allocation of resources.
Resource Allocation in the United States
o U.S. always considered the leading example of a market economy.
o Even in the US there are numerous cases of resource allocation
outside the market. Many economic decisions are made within
families, which do not operate like little market economies.
o In the broader economy, there are many examples of resource
allocation by command. Various levels of government collect, in
total, about one-third of our income as taxes.
o In this way the government plays a major role in allocating
resources-especially in determining which goods are produced and
who gets them.
o Also, regulations designed to protect the environment, maintain
safe workplaces, and ensure the safety of our food supply are just
a few examples of government imposed constraints on our
o The complete label for the United States is market capitalism. While
the market describes how resources are allocated, capitalism refers
to one way resources are owned.
o Under capitalism, most resources are owned by private citizens,
who are mostly free to sell or rent them to others as they wish.
o On the other hand, socialism is a type of economic system in
which most resources are owned by the state.
Understanding the Market
o The market is simultaneously the most simple and the most
complex way to allocate resources. o For individual buyers and sellers, the market is simple. There are
no traditions or commands to be memorized and obeyed. Instead,
we enter the markets we wish to trade in, and we respond to prices
there as we wish to, unconcerned about the overall process of
o From the economist’s point of view the market is quite complex.
Resources are allocated indirectly, as a byproduct of individual
decision making, rather than through easily identified traditions or
commands. As a result, it often takes some skillful economic
detective work to determine just how individuals are behaving and
how resources are being allocated as a consequence.
Using the Theory: Are We Saving Lives Efficiently
See appendix Chapter Three: Supply and Demand
Supply and Demand is an economic model, designed to explain how prices are
determined in certain types of markets.
A market is a group of buyers and sellers with the potential to trade with
Economists think of the economy as a collection of markets.
Characterizing a Market
The first step in analyzing a market is to determine which market we are analyzing.
Broad vs. Narrow Definition
o Aggregation- the process of combining distinct things into a single
o In economics, markets can be defined broadly or narrowly,
depending on our purpose.
o In macroeconomics, goods and services are aggregated to the
highest levels, in microeconomics markets are defined more
o There is some aggregation in microeconomics but not as much as
o While a macroeconomist may ask how much we spend on
consumer goods, while a microeconomist may ask how much we
might spend on health care or video games.
Product and Resource Markets
o Circular flow- a simple model that shows how goods, resources,
and dollar payments flow between households and firms.
o The upper half of the circular flow model illustrates the product
markets which are markets where firms sell goods and services to
o *In the real world, businesses also sell products to the government
and to other businesses, but this simple version leaves out these
o The lower half of the circular flow model depicts resource
markets where labor, land and capital are bought and sold. In this
market, households that own resources sell them to firms.
Competition in Markets
o A final issue in defining a market is how prices are determined. o In some markets, individual buyers or sellers have an important
influence over the price.
o Imperfectly competitive markets- a market in which a single
buyer or seller has the power to influence the price of a product.
o Perfectly competitive markets or competitive markets- a
market in which no buyer or seller has the power to influence the
o In perfectly competitive markets, there are many buyers and
sellers, each is a small part of the market, and the product is
standardized like wheat.
o Imperfectly competitive markets, by contrast, have just a few large
buyers or sellers, or else the product of each seller is unique in
o The supply and demand model is designed to show how prices are
determined in perfectly competitive markets.
Competition in the Real World
o Truly perfectly competitive markets are rare.
o For example, in the market for laptops there is no single market
price that all producers take as given, the market is not strictly
perfectly competitive. But laptops made by different firms, while
not identical, are not that different.
o While few markets are strictly competitive, most markets have
enough competition for supply and demand to explain broad
movements in price.
The quantity demanded of a good or service is the number of units that all buyers
in a market would choose to buy over a given time period, given the constraints
Quantity Demanded Implies a Choice
o It tells us how much households would choose to buy when they
take into account the opportunity cost of their decisions.
Quantity Demanded is Hypothetical
o Quantity demanded makes no assumptions about the availability of
Quantity Demanded Depends on Price The Law of Demand states that when the price of a good rises and everything
else remains the same, the quantity of the good demanded will fall.
The law of demand tells us what will happen if all the other influence’s on
buyers’ choices remain unchanged and only one influence-the price of the
“ceteris paribus”- Latin for “all else remaining the same”
The Demand Schedule and the Demand Curve
Demand schedule: A list showing the quantities of a good that consumers
would choose to purchase at different prices, with all other variables held
The demand curve shows the relationship between the price of a good
and the quantity demanded in the market, holding constant all other
variables that influence demand. Each point on the curve shows the total
quantity that buyers would choose to buy at a specific price.
Virtually all demand curves shift downwards.
Shifts versus Movements Along the Demand Curve
o A change in the price of a good causes a movement along the
o A change in any variable that affects demand-except for the good’s
price-causes the demand curve to shift.
o If buyers would want to buy a greater quantity at any price the
demand curve shifts rightward. If they would decide to buy a
smaller quantity at any price it would shift leftward.
“Change in Quantity Demanded” versus “Change in Demand”
o The term quantity demanded means a particular amount that
buyers would choose to buy at a specific price, represented by a
single point on a demand curve. Demand, by contrast, means the
entire relationship between price an quantity demanded,
represented by the entire demand curve.
o Change in quantity demanded: a movement along a demand curve
in response to a change in price.
o Change in demand: a shift of a demand curve in response to a
change in some variable other than price.
Factors that Shift the Demand Curve
Income- the amount that a person or firm earns over a particular period. o Normal good- a good that people demand more of as their income
o Inferior good- a good that people demand less of as their income
o A rise in income will increase the demand for a normal good, and
decrease the demand for an inferior good.
Wealth- the total value of everything a person or firm owns, at a point in
time, minus the total amount owed.
o An increase in wealth will increase demand (shift the curve
rightward) for a normal good, and decrease demand (shift the
curve leftward) for an inferior good.
Prices of Related Goods
o A substitute is a good that can be used in place of some other good
and that fulfills more or less the same purpose.
o When the price of a substitute rises it increases the demand for a
good, shifting the demand curve to the right.
o A complement is a good that is used together with some other
o A rise in the price of a complement decreases the demand for a
good, shifting the demand curve to the left.
o As the population increases in an area, the number of buyers will
ordinarily increase as well, and the demand for a good will increase.
o In many markets, an expectation that price will rise in the future
shifts the current demand curve rightward, while an expectation
that price will fall shifts the demand curve leftward.
o When tastes change towards a good, demand increases, and the
demand curve shifts to the right.
o When tastes change away from a good, demand decreases, and the
demand curve shifts to the left.
Other Shift Variables: government subsidies, etc.
Supply can change, and the amount of a good supplied in a market
depends on the choices made by those who produce it. We assume that those who supply goods and services have a goal: to
earn the highest profit possible. However, they also face constraints.
First, in a competitive market, the price they can charge for their product
is a given-the market price.
Second, firms have to pay the costs of producing and selling their
Quantity supplied- is the number of units of a good that all sellers in the
market would choose to sell over some time period, given the constraints
that they face.
Quantity Supplied Implies a Choice
o It’s the quantity that firms choose to sell-the quantity that gives
them the highest profit given the constraints they face.
Quantity Supplied Is Hypothetical
o Quantity supplied makes no assumption’s about the firms’ ability to
sell the good.
Quantity Supplied Depends on Price
o The price of the good is just one variable among many that
influences quantity supplied.
The Law of Supply
Price and quantity supplied are positively related.
The Law of Supply states that when the price of a good rises, and
everything else remains the same, the quantity of the good supplied will
The Supply Schedule and The Supply Curve
Supply Schedule- A list showing the quantities of a good or service that
firms would choose to produce and sell at different prices, with all other
variables held constant.
Supply Curve- shows the relationship between the price of a good and the
quantity supplied in the market, holding constant the values of all other
variables that affect supply. Each point on the curve shows the quantity
that sellers would choose to sell at a specific price.
The supply curve is upward sloping.
Shifts versus Movements Along the Supply Curve
A change in price causes a movement along the supply curve.
A change in any variable that affects supply-except for the good’s price-
causes the supply curve to shift. If sellers want to sell a greater quantity at any price, the supply curve
If sellers would prefer to sell a smaller quantity at any price, the supply
Change in Quantity Supplied versus Change in Supply
o Quantity supplied means a particular amount that sellers would
choose to sell at a particular price, represented by a particular point
on the supply curve.
o The term supply, however, means the entire relationship between
price and quantity supplied, as represented by the entire supply
o Change in quantity supplied: a movement along the supply curve in
response to a price change.
o Change in supply: a shift of a supply curve in response to a change
in some other variable other than price.
Factors That Shift the Supply Curve
Input prices- A fall in the price of an input causes an increase supply,
shifting the supply curve to the right
Price of alternatives
o Alternate goods- other goods that firms in a market could
produce instead of the good in question.
o Alternate market- a market other than the one being analyzed in
which the same good could be sold.
o When the price for an alternative rises-either an alternate good or
the same good in an alternate market-the supply curve shifts
Technology- a technological advance in production occurs whenever a firm
can produce a given level of output in a new and cheaper way than
o Cost-saving technological advances increase the supply of a good,
shifting the supply curve to the right.
Number of firms- an increase in the number of sellers-with no other
changes-shifts the supply curve rightward.
Expected Price- In many markets, an expectation of a future price rise
shifts the current supply leftward. Similarly, an expectation of a future
price drop shifts the current supply curve rightward. Changes in weather and other natural events- Favorable weather
increases crop yields, and causes a rightward shift of the supply curve for
that crop. Unfavorable weather destroys crops and shrinks yields, and
shifts the supply curve leftward.
Other shift variables- ex. Taxes
Putting Supply and Demand Together
When a market is in equilibrium, both the price of the good and the quantity bought
and sold have settled into a state of rest.
Equilibrium price- the market price that, once achieved, remains constant
until either the demand curve or supply curve shifts.
Equilibrium quantity- the market quantity bought and sold per period
that, once achieved, remains constant until either the demand curve or
the supply curve shifts.
Finding the Equilibrium Price and Quantity
Prices Below the Equilibrium Price
o Excess demand- at a given price, the amount by which quantity
demanded exceeds quantity supplied.
o Prices would rise as buyers would offer to pay a higher price, rather
than do without it. As prices rise buyers would demand a smaller
quantity which is a leftward movement along the demand curve, as
prices rise sellers increase supply which is a rightward movement
along the supply curve. When the price reaches a equilibrium,
excess demand is gone and prices stop rising.
Prices Above the Equilibrium Price
o Excess supply- at a given price, the amount by which quantity
supplied exceeds quantity demanded.
o Sellers would compete with each other to sell more maple syrup
than buyers wanted to buy and prices would fall.
o The drop in price would be a leftward movement on the supply
curve and a rightward movement on the demand curve.
o These movements would continue until excess supply disappears.
Equilibrium On A Graph
o To find the equilibrium in a competitive market, draw the supply
and demand curves. Market equilibrium occurs where the two
curves cross. At this crossing point, the equilibrium price is found on the vertical axis, and the equilibrium quantity on the horizontal
What Happens When Things Change
Example: Income Rises, Causing an Increase in Demand
o A rightward shift in the demand curve causes a rightward
movement along the supply curve. Equilibrium price and
equilibrium quantity both rise.
Example: Bad Weather, Supply Decreases
o A leftward shift of the supply curve causes a leftward movement
along the demand curve. Equilibrium price rises, but equilibrium
Example: Higher Income and Bad Weather Together
o We can’t say what will happen to equilibrium quantity until we
know which shift is greater and has the greater influence. Quantity
can rise, fall, or remain the same.
The Three-Step Process
Step 1: Characterize the Market
o Decide which market or markets best suit the problem being
analyzed, and identify the decision makers (buyers and sellers)
who interact there.
Step 2: Find the Equilibrium
o Describe the conditions necessary for equilibrium in the market,
and a method for determining that equilibrium.
o In this chapter we used supply and demand to find the equilibrium
price and quantity in a perfectly competitive market.
Step 3: What Happens When Things Change
o Explore how events or government policies change the market
Using the Theory: The Oil Price Spike of 2007-2008
See book Chapter Four: Working with Supply and Demand
Government Intervention in Markets
Fighting the Market: Price Ceilings
o A price ceiling is a government imposed maximum price in a
o When quantity supplied and quantity demanded differ, the short
side of the market-whichever of the two quantities is smaller-will
o Shortage- an excess demand not eliminated by a rise in price, so
that quantity demanded continues to exceed quantity supplied.
o A price ceiling creates a shortage and increases the time and
trouble required to buy the good. While the price decreases, the
opportunity cost may rise.
o The government may not be able to prevent a black market,
where goods are sold illegally at prices higher than the legal ceiling.
The black market price will typically exceed the original,
freely determined equilibrium price.
o the unintended consequences of price ceilings-long lines, black
markets, and, often higher prices-explain why they are generally a
poor way to bring down prices.
o Permanent or semi permanent price ceilings are exceedingly rare.
o An Example: Rent Controls
Rent controls- Government-imposed maximum rents on
apartments and homes.
Most states have laws prohibiting rent control but more than
a dozen states allow it including (NY, CA, MD and NJ).
Rent controls often do not go to those who they are
targeting, they create persistent excess demand which leads
to buyers facing more time and trouble to find an apartment
and they often end up paying market price or higher. Also
rent controls cause a decrease in the quantity of apartments
supplied which could and often times does lead to higher
Fighting the Market: Price Floors
o Sometimes governments try to help sellers of a good by
establishing a price floor-a minimum amount below which the
price is not permitted to fall. o Most common use of price floors in the world has been to raise or
prevent prices from falling in agricultural markets.
o Price floors for agricultural goods are commonly called price
o In the United States price support programs began during the
Great Depression after farm prices fell by more than 50% between
1929 and 1932.
o The Agricultural Adjustment Act of 1933, and an amendment in
1935, gave the president the authority to intervene in markets for
a variety of agricultural goods.
o The price floor prevents the excess supply from pushing the market
price back down to its equilibrium value, which results in a surplus.
o Surplus- an excess supply not eliminated by a fall in price, so that
quantity supplied continues to exceed quantity supplied.
o Maintaining a Price Floor
The government promises to buy any unsold product at a
guaranteed price, this reduces the temptation for farmers to
illegally sell their product at a lower price to sell all of their
A price floor creates a surplus of a good. In order to maintain
the price floor the government must prevent the surplus
from driving down the market price. In practice, the
government often accomplishes this goal by purchasing the
Price floors are usually accompanied by government efforts
to limit any excess supplies.
Price floors often get the government deeply involved in
production decisions, rather than leaving them to the
Manipulating the Market: Taxes
o A tax on a specific good or service is an excise tax.
o An Excise Tax on Sellers
A tax collected from sellers shifts the supply curve upward by
the amount of the tax. Tax infidence- the division of a tax payment between
buyers and sellers, determined by comparing the new (after
tax) and old (pretax) market equilibriums.
The incidence of a tax that is collected from sellers
o An Excise Tax on Buyers
A tax collected from buyers shifts the demand curve
downward by the amount of the tax.
The incidence of a tax that is collected from buyers falls on
both sides of the market. Buyers pay more, and sellers
receive less, for each unit sold.
o Tax Incidence Versus Tax Collection
The numerical incidence of any tax will depend on the shapes
of the supply and demand curve.
The incidence of the tax (the distribution of the burden
between buyers and sellers) is the same whether the tax is
collected from buyers or sellers.
Manipulating the Market: Subsidies
o A subsidy is the opposite of a tax.
o Subsidy- a government payment to buyers or sellers on each unit
purchased or sold. A subsidy lowers prices to buyers and
encourages people to buy it.
o A Subsidy to Buyers
A subsidy paid to buyers shifts the demand curve upward by
the amount of the subsidy.
A subsidy paid to buyers benefits both sides of a market.
Buyers pay less and sellers receive more for each unit sold.
Look in book for education example!
o A Subsidy to Sellers
The distribution of benefits from a subsidy is the same,
regardless of whether the subsidy is paid to buyers or
Supply and Demand in Housing Markets
A requirement for analyzing a market is that there are many buyers and sellers,
and each regards the market price as given.
What’s Different About Housing Markets? o Most of the homes that people own, and most that changes hands
each year, were originally built and sold lone before.
A Detour: Stock and Flow Variables
A stock variable measures a quantity in existence at a
moment in time. (15 gallons in tub)
A flow variable measures a process that takes place
over a period of time. (2 gallons per minute)
Number of homes that people own at a given time is
referred to as the housing stock.
New home construction and new home purchases are
flow variables: so many homes are built or purchased
per month or per year.
It is best to think of the supply and demand for homes
in terms of the housing stock.
When looking at it this way, the equilibrium occurs
when the total number of homes people want to own
is equal to the total number available for ownership
(the housing stock).
Supply and Demand Curves in a Housing Market
o The supply curve for the housing stock is vertical because it’s fixed.
o The demand curve tells us the number of families who want to be
homeowners at each price.
Behind the Demand Curve: Ownership Costs
o Anyone deciding whether to be a homeowner will compare the cost
of ownership with the next best thing: renting.
o Home Prices and Monthly Costs for Prospective Owners
The greater the purchasing price, the greater the monthly
interest forgone because it is used towards the house rather
than being in an account where interest could be earned.
Many times homeowners get a mortgage, a loan given to
homeowners for part of the purchase price of the home.
For a prospective homeowner, the monthly cost of owning a
home will vary directly with the price of the home.
o Home Prices and Monthly Costs for Current Owners
Any change in the home’s cost –even after it was purchased-
will change the owner’s monthly costs. Continued ownership means continued forgone interest.
Both current and prospective homeowners face a monthly
cost of ownership. This monthly cost rises when home prices
rise and fall when home prices fall.
When housing prices fall and nothing else changes, the
monthly cost of owning a home declines as well. With lower
monthly costs, more people will prefer to own rather than
rent, so the quantity of homes demanded increases.
o Shifts versus Movement Along the Demand Curve
A movement occurs when price of a home changes whereas
a shift occurs if any other factor besides price changes.
Housing Market Equilibrium
The equilibrium price in a housing market is the price at which the
quantity of homes demanded (the number of people who want to own)
and quantity supplied (the housing stock) are equal.
What Happens When Things Change
Over time both the supply and demand curves will shift rightward. The
supply curve shifts rightward as the housing stock rises (new homes are
built). The demand curve shifts rightward for a variety of reasons
including population growth and rising incomes.
The market equilibrium will move rightward over time as well, but what
happens to home prices depends on the relative shifts in the supply and
Equal Changes in Supply and Demand: A Stable Housing Market
o When the housing stock grows at the same rate as housing
demand, house prices remain unchanged.
o This is not entirely realistic because in housing markets,
construction costs for labor and raw materials tend to rise over
time. In order to cover these rising costs and continue increasing
the housing stock, average home prices must rise over time, at
Restrictions on New Building: Rapidly Rising Prices
o When restrictions on new building prevent the housing stock from
growing as fast as demand, housing prices rise. Can explain why
housing prices have increased so rapidly in cities in NY and CA.
Faster Demand Growth: Rapidly Rising Prices o A house can also be an asset.
o Capital gain: the gain to the owner of an asset when it is sold for a
price higher than its price when originally purchased.
o Capital loss: The loss to the owner of an asset when it is sold for a
price lower than its price when originally purchased.
o Anticipated capital gains are one of the reasons that most people
hold assets, including homes.
o A home is one of the most leveraged financial investments that
people can ever make.
o Leverage magnifies the impact of a price change on the rate of
return you will get from an asset.
o When home prices, your rate of return from investing in a home
can be several times the percentage growth in housing prices.
o This makes the demand for housing particularly sensitive to
changing expectations about future home prices.
o It takes time for the housing stock to catch up to the change in
demand because the year’s housing stock is based on construction
started in the previous year and it takes time. When housing prices
rise there is more incentive to build but it takes time to catch up.
o When the demand for housing begins rising faster than previously,
the housing stock typically lags behind, and housing prices rise.
Using the Theory: The Housing Boom and Bust of 1997-2008
See Book Chapter Five: Elasticity
Elasticities are measures of the sensitivity of one variable to another.
Price Elasticity of Demand
Price elasticity of demand measures the sensitivity of quantity demanded
to the price of the good itself.
Problems with Slope
The slope of a demand curve depends on arbitrary units of
measurement that we happen to choose.
Also, the slope of the demand curve doesn’t tell us anything about
the significance of a change in price or quantity-whether it is
relatively small or a relatively large change.
The Elasticity Approach
o The elasticity approach solves both of these problems by comparing
the percentage change in quantity demanded with the percentage
change in price.
o The price elasticity of demand for a good is the percentage
change in quantity demanded divided by the percentage change in
price. It is the sensitivity of quantity demanded to price; the
percentage change in quantity demanded caused by a 1 percent
change in price.
in this book we’ll look at elasticity in absolute terms.
The greater the elasticity value, the more sensitive quantity
demanded is to price.
Calculating Price Elasticity of Demand
o When calculating the price elasticity of demand we imagine that
only price is changing, while we hold constant all other influences
on quantity demanded, such as buyers’ incomes, the prices of other
goods and so on. Essentially, we measure elasticity for a movement
along an unchanging demand curve.
o Elasticity value will also depend on the direction moved (upward or
o When determining elasticities
o We calculate the percentage change in a variable using the
midpoint formula: the change in the variable divided by the
average of the old and new values.
o Look art book for % change in price and % change in quantity
demanded formulas. o We use the midpoint formula only when calculating elasticity values
from data on prices and quantities. For all other purposes, we
calculate percentage change in the normal way, using the starting
value as the base.
o Perfectly Inelastic Demand- a price elasticity of demand equal
A perfectly inelastic demand curve is vertical, so a change in
price causes no change in quantity demanded.
o Inelastic Demand- a price elasticity of demand between 0 and 1.
(quantity changes by a smaller % than price).
o Elastic Demand- A price elasticity of demand greater than 1
(quantity changes by a larger percentage than price changes).
o Perfectly (infinitely) Elastic Demand- a price elasticity of
demand approaching infinity
As long as the price stays at one particular value, any
quantity might be demanded. But even the tiniest price rise
would cause quantity demanded to fall to 0.
o Unit Elastic Demand-a price elasticity of demand equal to 1.
Elasticity and Straight-Line Demand Curves
o Elasticity is the ratio of percentage changes; what remains constant
along a linear demand curve is the ratio of absolute or unit
o Elasticity of demand varies along a straight-line demand curve.
More specifically, demand becomes less elastic (Elasticity of
demand gets smaller as we move downward and rightward.
Elasticity and Total Revenue
o TR (Total Revenue) = P (Price per Unit) x Q (Quantity that people
o At any point on a demand curve, sellers’ total revenue is the area
of a rectangle with a height equal to price and width equal to
o An increase in price raises total revenue when demand is inelastic,
and shrinks total revenue when demand is elastic.
o A decrease in price shrinks total revenue when demand is inelastic,
and raises total revenue when demand is elastic. o If demand is unit elastic a 1 percent change in price would cause a
1 percent change in quantity and they would cancel each other out.
Determinants of Elasticity
o Availability of Substitutes
When close substitutes are available for a good, demand will
be more elastic.
One factor that determines the closeness of substitutes is
how narrowly or how broadly we define the market. Ex.
Demand in the market for soft drinks will be less elastic than
demand in the market for Coke.
This is because when determining the elasticity of demand in
a market, we hold constant all prices outside of the market.
o Necessities vs. Luxuries
When we regard something as “necessity,” demand for it will
tend to be less elastic.
Goods we regard as necessities tend to have less elastic
demand than goods we regard as luxuries.
Still with this the narrowness or broadness in the definition
of the market is important. Ex. Clothes would be inelastic
while designer jeans would be more elastic.
o Importance in Buyers’ Budget
When spending on a good makes up a large proportion of
families’ budgets, demand tends to be more elastic.
o Time Horizon
Short-run elasticity: An elasticity measured just a short time
after a price change.
Long-run elasticity: An elasticity measured a year or more
after a price change.
The longer we wait after a price change to measure the
quantity response, the more elastic is demand. Therefore,
long run elasticities tend to be larger than short-run
Time Horizons and Demand Curves
o Price elasticity of demand is measured along a demand curve.
o There can be more than one demand curve associated with a
specific market. whenever we draw a demand curve we do it for a specific
o Any demand curve is for a particular time horizon (a waiting period
before we observe the new quantity demanded after a price
change). In general, the longer the time horizon, the more elastic
Two Practical Examples
o Elasticity and Mass Transit
Several studies have shown that the demand for mass transit
is inelastic. This means that a rise in fares would likely raise
mass-transit revenue for a city, even in the long run.
Elasticity estimates come from past data on the response to
price changes. When we ask what would happen if we raise
the price, we are extrapolating from these past responses.
For small price changes the extrapolation would be fairly
accurate. But large price changes move us into unknown
territory and elasticity may change. Demand could be
elasticity for a very large price hike, and then total revenue
would fall. This puts a limit on fares, even if a city’s goal is
the maximum possible revenue.
Also generating revenue is only one consideration in setting
mass transit fares. City governments are also concerned with
providing affordable transportation to city residents, reducing
traffic congestion on city streets and limiting pollution. A fare
increase, even if it would raise total revenue, would work
against these other goals. This is why most cities keep the
price of mass-transit below the revenue-maximizing price.
o Elasticity and Oil Prices
The inverse of elasticity tells us the percentage rise in price
that would bring about each 1 percent decrease in quantity
See book for more
Elasticity can be used to measure the sensitivity of virtually any variable
to any other variable. All types of elasticity measures tell us the percentage change in one
variable caused by a 1 percent change in the other.
Income Elasticity of Demand
o The income elasticity of demand tells us how sensitive quantity
demanded is to changes in buyers’ incomes.
o Income elasticity of demand- The % change in quantity demanded
caused by a 1% change in income. All other influences on demand
are remaining constant.
o Income elasticity = (% change in QD) / (% change in income)
o While price elasticity measures the sensitivity of demand to prices
as we move along the demand curve from one point to another, an
income elasticity tells us the relative shift in the demand curve-the
percentage increase in quantity demanded at a given price.
o With income elasticities (unlike other elasticities) the sign of the
elasticity value matters.
o Income elasticity will be positive when people want more of a good
as their income rises, such goods are called normal goods.
o Income elasticity can also be negative, when a rise in income
decreases demand for a good (inferior goods).
o Income elasticity is positive for normal goods and negative for
Cross-Price Elasticity of Demand
o A cross-price elasticity relates the percentage change in quantity
demanded for one good to the percentage change in the price of
o Cross-price elasticity of demand is the percentage change in the
quantity demanded of one good caused by a 1 percent change in
the price of another good.
o We define the cross-price elasticity between good X and good Z as:
(% change in QD of X) / (% change in price of Z)
o With a cross-price elasticity (as with income elasticity), the sign
A positive cross-price elasticity means that the two goods are
substitutes. A rise in the price of one good increases the
demand for the other good. A negative cross-price elasticity means that the goods are
complements. A rise in the price of one good decreases the
demand for the other good.
Price Elasticity of Supply
o It is the percentage change in the quantity supplied of a good or
service that is caused by a 1 percent change in the price of the
good, with all other influences on supply held constant.
o Price Elasticity of Supply = (% change in QS) / (% change in price)
o The price elasticity of supply measures the sensitivity of quantity
supplied to price changes as we move along the supply curve.
o A large value for the price elasticity of supply means that quantity
supplied is very sensitive to price changes.
o A major determinant of supply elasticity is the ease at which
suppliers can find profitable activities that are alternatives to
producing the good in question.
Supply will tend to be more elastic when suppliers can switch
to producing alternate goods more easily.
The nature of the good plays a role in the ability to switch
production to alternative goods.
The narrowness of the market definition matters too-
especially geographic narrowness. Ex. The market for
oranges in Illinois would be more supply-elastic than the
market for oranges in the United States. In the Illinois
market, a decrease in price implies that we are holding
constant the price of oranges in all other states. This gives
suppliers and easy alternative, they could sell their oranges
in other states.
The time horizon is also important. The longer we wait after
a price change, the greater the supply response to a price
Supply for many products becomes more elastic the longer
we allow sellers to respond to a price change. In general,
long-run supply elasticities are greater than short-run supply
Using the Theory
See Book Chapter Six: Consumer Choice
The Budget Constraint
Two facts of economic life: (1) We have to pay for the goods and services
we buy, and (2) we have limited funds to spend
A consumer’s budget constraint identifies which combination of goods
and services the consumer can afford with a limited budget, at given
Budget line- The graphical representation of a budget constraint,
showing the maximum affordable quantity of one good for given amounts
of another good.
o Any point below or to the left of the budget line is affordable.
o The budget line serves as a border between those combinations
that are affordable and those that are not.
o Relative Price- The price of one good relative to the price of
another (one money price divided by another money price).
o The relative price of a concert, the opportunity cost of another
concert, and the slope of the budget line have the same absolute
o The slope of the budget line indicates the spending tradeoff
between one good and another-the amount of one good that must
be sacrificed in order to buy more of another good. If P sub-y is the
price of the good on the vertical axis and P sub-x is the price of the
good on the horizontal axis, then the slope of the budget line is
Changes in the Budget Line
o The “givens”-the prices of the goods and the consumer’s income-
are always assumed constant as we move along a budget line; if
any one of them changes; the budget line will change as well.
o Changes in Income
An increase in income will shift the budget line upward (and
rightward). A decrease in income will shift the budget line
downward (and leftward). These shifts are parallel: changes
in income do not affect the budget line’s slope.
o Changes in Price
When the price of a good changes, the budget line rotates:
Both its slope and one of its intercepts will change.
o One common denominator-and critical assumption behind
consumer theory-is that people have preferences.
o Another common denominator is that preferences are logically
consistent, or transitive.
o When a consumer can make choices, and is logically consistent, we
say that she has rational preferences.
o Rational preferences are preferences that satisfy two conditions:
(1) Any two alternatives can be compared, and one is preferred or
else the two are valued equally, and (2) the comparisons are
logically consistent or transitive.
o Rationality is a matter of how you make your choices, and not what
choices you make.
More is Better
o Another feature of preferences that virtually all of us share is this:
We generally feel that more is better. Specifically, if we get more of
one good or service, and nothing else is taken away from us, we
will generally feel better off.
o The consumer will always choose a point on the budget line, rather
than a point below it.
o We can always find at least one point on the budget line that is
preferred, as long as more is better.
o There are two theories of consumer decision making that share
much in common. First, both assume that preferences are rational
and secondly, both assume that the consumer would be better off
with more of any good we’re considering.
o This means that the consumer will always choose a combination of
goods in, rather than below, his budget line. Both theories come to
the same general conclusion about consumer behavior. However, to
arrive at those conclusions, each theory takes a different road.
o Both approaches to consumer theory are models. Households or
consumers don’t actually use these techniques but rather our
assumption is that people mostly behave as if they use them.
Consumer Decisions: The Marginal Utility Approach
Economists assume that any decision-maker tries to make the best out of
any situation. Marginal utility theory treats consumers as striving to maximize their utility- an actual quantitative measure of well-being or
Utility and Marginal Utility
o Although Lisa’s utility increases every time she consumes more ice
cream, the additional utility she derives from each successive cone
gets smaller and smaller as she gets more cones.
o Marginal utility is the change in utility an individual enjoys from
consuming an additional unit of a good.
o Law of diminishing marginal utility- as consumption of a good
or service increases, marginal utility decreases.
o Because marginal utility is the change in utility caused by a change
in consumption from one level to another, we plot each marginal
utility entry between the old and new consumption levels.
o Diminishing marginal utility is seen by the downward sloping
marginal utility curve, and the positive but decreasing slope
(flattening out) of the total utility curve.
o When we use marginal utility theory, we assume that marginal
utility for every good is positive based on the assumption we make
that people always prefer more rather than less of any good.
Combining the Budget Constraint and Preferences
o The marginal utility someone gets from consuming more of a good
tells us about his preferences. By contrast, his budget constraint
tells us only which combination of goods he can afford.
o Marginal utility per dollar spent on concerts is found by dividing the
marginal utility of the last concert by the price of a concert. This
tells us the gain in utility Max gets for each dollar he spends on the
o Marginal utility per dollar, like marginal utility itself, declines as
Max attends more concerts.
o Highest possible utility is found where the marginal utility per dollar
is the same for both goods.
o For any two goods x and y, with prices Px and Py, whenever
MUx/Px > MUy/Py, a consumer is made better off shifting spending
away from y and toward x. When MUy/Py > MUx/Px, a consumer is
made better off shifting spending away from x and toward y. o A utility-maximizing consumer will choose the point on the budget
line where marginal utility per dollar is the same for both goods
(MUx/Px = MUy/Py). At that point, there is no further gain from
reallocating expenditures in either direction.
o Regardless of the amount of goods to choose from, when the
consumer is doing as well as possible, it must be true that Mux/Px
= MUy/Py for any pair of goods, x and y. If this condition is not
satisfied, the consumer will be better off consuming more one and
less of the other good in the pair.
What Happens When Things Change
o Changes in Income
A rise in income-with no change in prices-leads to a new
quantity demanded for each good. Whether a particular good
is normal (QD increases) or inferior (QD decreases) depends
on the individual’s preferences, as represented by the
marginal utilities for each good, at each point along his
o Changes in Price
Change in price rotates the budget line; a drop in price
rotates it rightward and an increase in price rotates it
o The Consumer’s Demand Curve
Income and Substitution Effects
The Substitution Effect
o The substitution effect of a price change arises from a change in
the relative price of a good, and it always moves quantity
demanded in the opposite direction to the price change. When price
decreases, the substitution effect works to increase quantity
demanded; when price increases, the substitution effect works to
decrease quantity demanded.
o The impact of a price decrease is called a substitution effect: the
consumer substitutes toward the good whose price has decreased,
and away from other goods whose prices have remained
unchanged. o The substitution effect is the main factor responsible for the law of
The Income Effect
o The income effect of a price change arises from a change in
purchasing power over both goods. A drop in price increases
purchasing power, while a rise in price decreases purchasing
o The income effect of a price cut can work to either increase or
decrease the quantity of a good demanded, depending on whether
the good is normal or inferior.
Combining Substitution and Income Effects
o A change in the price of a good changes both the relative price of
the good (the substitution effect) and the overall purchasing power
of the consumer (the income effect). The ultimate impact of the
price change will depend on both of these effects
o For normal goods, these two effects work together to push quantity
demanded in the same direction. For inferior goods, the two effects
oppose each other.
o Normal Goods
For normal goods, the substitution and income effects work
together, causing quantity demanded to move in the
opposite direction of the price. Normal goods, therefore,
must always obey the law of demand.
o Inferior Goods
In practice, the substitution effect virtually always dominates
for inferior goods.
For inferior goods, the substitution and income effects of a
price change work against each other. The substitution effect
moves quantity demanded in the opposite direction of the
price, while the income effect moves it in the same direction
as the price. But since the substitution effect virtually always
dominates, consumption of inferior goods-like normal goods-
will virtually always obey the law of demand.
Consumers in Markets
The market demand curve is found by horizontally summing the individual
demand curves of every consumer in the market. As long as each individual’s demand curve is downward sloping (and this
is virtually always the case), then the market demand curve will also be
If a rise in price makes each consumer buy fewer units, then it will reduce
the quantity bought by all consumers as well.
Indeed, the market demand curve can still obey the law of demand even
when some individuals violate it.
Consumer Theory in Perspective
Extensions of the Model
o One extension of the model is to incorporate choices among many
goods rather than just two.
o Another extension is to recognize saving and borrowing. A way to
incorporate these possibilities is to define one of the goods as
“future consumption.” In that case, saving means sacrificing
consumption of all goods now in order to have more future
consumption, and borrowing means the opposite.
o More difficult extensions incorporate uncertainty and imperfect
o Consumer theory always regards people relentlessly selfish,
concerned only about their own consumption. When people trade in
impersonal markets, this is mostly true: People do generally try to
allocate their spending among different goods to achieve the
greatest personal satisfaction.
o However, in many areas of economic life, people act unselfishly.
This, too, can be incorporated into the traditional model of
consumer theory. One way is to treat the “satisfaction of others”
(say, a family member or society at large) as another “good.”
o Behavioral economics has shown that preferences are sometimes
irrational, and people sometimes make decisions-even highly
consequential decisions-against their own interests, often in
predictable ways. It is a subfield of economics focusing on decision-
making patterns that deviate from those predicted by traditional
o Salience Consumers often make decisions based not just on the
outcome, but on the salience of a particular outcome-the
extent to which it “jumps out at them.”
Salience also plays a role in major economic decisions, such
as taking out mortgage loans, borrowing on credit cards, or
Corporations exploit salience by arranging documents or
keep certain facts from standing out.
o Preference for Defaults
If choices are based on rational preferences, the “default
choice” should not matter.
Studies have shown that people tend to stick to the default
choice for some decisions.
Ex. Companies having “opt in for email” selected when
people sign up for accounts and making them uncheck it to
not get the emails.
o Decision-Making Environment
Sometimes, the environment in which a decision is made can
exert a strong and surprising influence.
This violates traditional consumer theory, where preferences
are assumed to be based on a comparison of alternatives,
and not on how or where the alternatives are presented.
Retailers know that the environmental context matters, and
try to influence purchasing decisions by controlling the music
in the store, the scent in the air, or even the thickness
beneath customers’ feet.
A decision-maker should always prefer a wide array of
choices to a narrow one.
However, in daily life we see decision-makers contradict this
principle just as Ulysses did. They would prefer to bind
themselves to a narrow set of choices, for their own long-run
o Behavioral Economics and Policy
o Behavioral Economics and Traditional Theory Traditional economic theory assumes that consumers have
Behavioral economics analyzes decisions that violate rational
The best model to use depends on the issue we are
In most markets, most of the time, consumer responses can
be understood very well with the traditional model.
Gas tax affect on demand for cars (traditional) vs. why
consumers buy certain cars that trap them into buying more
Few economists see behavioral economics as an alternative
to traditional economics, rather they see it as an addition.
Using the Theory: Improving Education
Appendix: The Indifference Curve Approach
An Indifference Curve
o An indifference curve represents all combinations of two goods
that make the consumer equally well off.
o The Marginal Rate of Substitution (MRS)
The marginal rate of substitution of good y for good x along
any segment of an indifference curve is the maximum rate at
which a consumer would willingly trade units of y for units of
o MRS at a point
MRS depends on the size of the segment we are considering.
The MRS at any point on the indifference curve is equal to
(the absolute value of) the slope of the curve at that point.
When measured at a point, the marginal rate of substitution
of good y for good x tells us the maximum rate at which a
consumer would willingly trade good y for a tiny bit more of
o How MRS Changes Along an Indifference Curve
As we move down an indifference curve, the MRS gets
smaller and smaller. This is because initially he, for example
would see a lot of movies and not a lot of concerts, he would value another concert more highly but as he sees more and
more concerts he will not value them as much as he did
The Indifference Map
o An indifference map is a set of indifference curves that describe
Max’s preferences, like the curves in figure A.2.
o Any point on a higher indifference curve is preferred to any point
on a lower one.
o An indifference map gives us a complete characterization of
someone’s preferences: It allows us to look at any two points and-
just by seeing which indifference curves they are on-immediately
know which, if either, is preferred.
Consumer Decision Making
o An optimal combination of goods for an individual to make them as
well off as possible will (1) be a point on his budget line, and (2) it
will lie on the highest indifference curve possible.
o When an indifference curve actually crosses the budget line, we can
always find some other point on the budget line that lies on a
higher indifference curve.
o The absolute value of the indifference curve’s slope-the MRS-tells
us the rate at which Max would willingly trade movies for concerts.
o The slope of the budget line, by contrast, tells us the rate at which
Max is actually able to trade movies for concerts.
o If there’s any difference between the rate at which Max is willing to
trade one good for another and the rate at which he is able to
trade, he can always make himself better off by moving to another
point on the budget line.
o The optimal combination of goods for a consumer is the point on
the budget line where an indifference curve is tangent to the
o The optimal combination of two goods x and y is that combination
on the budget line for which MRS (goods y and x) = Px/Py.
What Happens When Things Change?
o Changes in Income
A rise in income, with no change in prices, leads to a new
quantity demanded for each good. Whether a particular good is normal (QD increases) or inferior (QD decreases) depends
on the individual’s preferences, as represented by his
o Changes in Price
Rotate the budget line (drop in prices rotates it rightward)
The Individual’s Demand Curve
o See book Chapter Seven: Production and Cost
A firm’s managers strive to earn the highest possible profit, the difference between
a firm’s revenues and its costs. Controlling costs is one way to increase profits.
Business firm- An organization, owned and operated by private
individuals, that specializes in production.
Production is the process of combining inputs to make goods and services.
Production creates both goods and services.
The inputs used in production include the four resources (land, labor,
capital, and entrepreneurship) plus other goods, like paper, ink and
Technology and Production
o Technology- the methods available for combining inputs to
produce a good or service.
o If the firm’s technology allows it to use different methods for
producing the same level of output, we assume the firm will use the
cheapest method it can find.
o In this chapter we’ll spell out the production technology for a
mythical firm that uses only two inputs: capital and labor.
Short-Run versus Long-Run Decisions
o When a firm changes its level of production, it will want to adjust
the amount of inputs it uses. These adjustments depend on the
time horizon the firm’s managers are thinking about. Some inputs
can be adjusted relatively quickly while others may take longer to
o Time horizons firms can use can be split up into two broad
categories: long-run and short-run
The long-run is a time period long enough for a firm to
change the quantity of all its inputs.
Over the long-run, all the inputs the firm uses are viewed as
variable inputs, an input whose usage can change as the
level of output changes.
In shorter time periods the company may be stuck with the
current quantities of some inputs. Fixed inputs are inputs,
that the time period we’re considering, cannot be adjusted as
output changes. The short-run is a time period during which at least one of
the firm’s inputs is fixed.
Production in the Short-Run
When firms make decisions in the short-run, there is nothing they can do
about their fixed inputs: they are stuck with whatever quantity they have.
However, they can make choices about their variable inputs.
Total Product (Q)- the maximum quantity of output that can be
produced from given combination of inputs.
o In the table, the total product numbers tell us the maximum output
for each numbers of workers.
o For each value of the total product, the labor column shows us the
lowest number of workers that can produce it. Because labor is the
only variable input, this lowest number of workers will also be the
least-cost method of producing any level of output.
o The total product curve shows the total amount of output that
can be produced using various numbers of workers. The marginal
product of labor (MPL) is the change in total product when another
worker is hired.
o The marginal product of labor (MPL) is the change in the total
product (^Q) divided by the change in the number of workers
employed (^L): MPL = Change in total product (^Q) / Change in
the number workers employed (^L)
Marginal Returns to Labor
o As more and more workers are hired, the MPL first increases (the
vertical arrow grows longer) and then decreases (the arrows get
o Increasing Marginal Returns to Labor
When the marginal product of labor increases as more
workers are hired, there are increasing marginal returns
This may happen because more workers may allow
production to become more specialized.
o Diminishing Marginal Returns to Labor
When the marginal product of labor is decreasing, we say
that there are diminishing marginal returns to labor. Output still rises when another worker is added, so
marginal product is positive. But the rise in output is
smaller and smaller with each successive worker.
This occurs because as workers keep being added
additional gains from specialization will be harder to
achieve and each worker will have less and less of the
fixed inputs with which to work.
The last point applies to all kinds of production: as we
keep increasing the quantity of any one input, while
holding the others fixed, diminishing marginal returns
will eventually set in.
The law of diminishing (marginal) returns states that as
we continue to add more of any one input (holding the other
inputs constant), its marginal product will eventually decline.
The law of diminishing returns is a physical one and not an
economic one. It is based on the nature of production-on the
physical relationship between inputs and outputs with a
Thinking About Costs
Production is the physical relationship between inputs and outputs.
A firm’s total cost of producing a given level of output is the opportunity
cost of the owners-everything they must give up in order to produce that
amount of output.
The Irrelevance of Sunk Costs
o A sunk cost is one that has already been paid, or must be paid,
regardless of any future action being considered.
o Sunk costs should not be considered when making decisions.
o In the textbook example, what should be considered are the costs
that do depend on the decision about producing the drug, namely,
the cost of actually manufacturing it and marketing it for the
smaller market. If the costs are less than the earnings in annual
revenue then ACME should do it.
o Even a future payment can be sunk, if an unavoidable commitment
to pay it has already been made.
Explicit versus Implicit Costs o Explicit costs involve actual payment while implicit costs involve no
money changing hands.
o Using a building you already owned for a restaurant may be free in
the eyes of an accountant but to an economist it is not because you
could be renting it out to someone else.
The foregone rent is an implicit cost, and it is as much a cost
of production as the rent you would pay if you didn’t own a
o Foregone interest is another implicit cost of the business because
the money used to start it could be in the bank or lent to someone
o Becoming manager of the business doesn’t escape the costs of
hiring one because you could do something else with your time and
the foregone labor income is yet another implicit cost of your
business and is therefore part of the opportunity cost.
Cost in the Short Run
No matter how much output is produced, the quantity of a fixed input
must remain the same. Other inputs, by contrast, can be varied as output
Because a firm has these two different types of inputs in the short run, it
will also face two different types of costs.
The cost of a firm’s fixed inputs are called fixed costs.
o Fixed costs remain the same regardless of the level of output.
o We regard rent and interest-whether explicit or implicit-as fixed
costs, since producing more or less output in the short run will not
cause these costs to change.
o Managers typically refer to fixed costs as overhead costs or just
The cost of obtaining the firm’s variable inputs are its variable costs.
o These costs will rise as output increases along with the variable
o Most businesses treat the wages of hourly employees and the costs
of raw materials as variable costs, because quantities of labor and